CLO 3.0 – The Regulatory Evolution for US CLOs

In what can only be described as a regulatory war of attrition, special purpose vehicles (“SPVs”) issuing US collateralised loan obligations (“CLOs”), have faced a raft of global initiatives and regulatory changes over the past six plus years that have forced CLO structures to evolve at the issuer level. From an SPV directorʹs perspective, this ever mounting regulatory responsibility has ushered in the new era of CLO 3.0.

While the post-credit crisis era saw the emergence of CLO 2.0 structures, in what was a seismic shift, with documentation  and structural  improvements introduced to CLO 1.0 deals in response to the collapse of sub-prime mortgages in the US, the journey from CLO 2.0 to CLO 3.0 has been somewhat more surreptitious.  As numerous regulatory initiatives have directly or indirectly been imposed on CLO structures, significantly greater burdens have been placed on arrangers, investment managers, trustees and, inevitably, on the directors of the SPVs themselves.

With no slowdown in the relentless pace of regulatory change in sight, the traditionally more passive role of directors of CLOs has morphed into something more akin to that of regulatory gatekeepers.  Not only does this require an immense level of in-depth knowledge to ensure that the SPVs for which they act remain compliant across a number of supervisory fronts, but it also requires a significantly increased time commitment and greater experience so as to handle the numerous issues that continue to arise throughout the life of a CLO transaction.

Since 2012, CLOs have been caught up in the global supervisory onslaught from US lawmakers, European legislators and supranational bodies like the OECD, not to mention having to deal with additional measures at the transactional level, such as enhanced anti-money laundering procedures and new accounting requirements.  This has created a significant additional compliance burden for CLO arrangers and investment managers, who have inevitably passed some of that workload on to their CLO trustees and directors.

Whilst compliance with US regulatory requirements like the Foreign Account Tax Compliance Act (“FATCA”) has now become routine, transactions with a European component or with EU or non-US investors, also involve compliance with the Common Reporting Standards (“CRS”) which remain a moving target due to the sheer number of jurisdictions who have signed up.  All of this has been compounded by jurisdictional specific Anti-Money Laundering (“AML”) regulations, the introduction of enhanced Market Abuse Regulations in the EU affecting all CLOs listed on EU stock exchanges, on-going risk retention related concerns in the EU and, more recently, in Japan, and the new global focus on country by country reporting and economic substance.  Taken together, this has all resulted in a quantum shift in the level of specialised knowledge needed, and the institutional support required, by parties looking to service CLO transactions.

What that means, in the context of ever increasing market activity, is that arrangers and investment managers need to think strategically and carefully before choosing their CLO service providers, ensuring that they partner with firms with recognised longevity in the space and an ownership that is committed to investing in the business over the long term.  Firms that understand the market and its requirements and which have the resources, knowledge  and commitment to ensure those deals are properly serviced from start to finish.  Directors of these transactions have to possess the necessary expertise to deal with the resulting complexity and, equally importantly, they need the support that a larger service provider can provide in order to handle the vast array of regulatory requirements now facing the sector. The days of smaller shops or start-ups, with little or no resources behind them are long gone.

US Regulations Bite

From a US perspective, a sharp uptick in SEC enforcement actions since 2012, resulting from the Commission’s adoption of its ʹbroken windowsʹ policy, has left significantly more investment advisors and SPV issuers facing audits, where regulators drill down into issues like conflicts of interest, allocated costs, cybersecurity and the robustness of IT and other systems. This has led to significantly greater scrutiny and more focus being placed on transactions such as S.206 Investment Advisor Act consent mechanisms for principal and affiliated trades.  Although the appointment of Jay Clayton as SEC Chairman by President Trump in 2017 heralded what was then seen as the end of the ʹbroken windowsʹ policy and the tough approach to  the  prosecution of minor infractions, more recent actions by the SEC, notably against US fund manager Talimco, for cross trade violations, demonstrate the regulatorʹs intent to continue to prosecute in this area.  This highlights the need for independent service providers who understand the intricacies of disclosure and the necessity of obtaining appropriate back-up and permissions for principal trades.

Over the same period, the introduction of Dodd Frank legislation and the Volcker Rule has presented numerous challenges to arranging banks in terms of their use of SPVs and fund vehicles.  These changes have meant greater use of independent general partners and commodity pool operators on investment fund platforms as well as more scrutiny over the autonomy of repack programmes leading, in some cases, to divestment of ownership.

Since 2014, service providers have also been forced to undertake a massive exercise across their fiduciary books to ensure compliance with FATCA.  Not only has this required significant education and training for staff, but has also necessitated considerable time and effort to bring trustees up to speed in terms of the necessary  reporting information required  from them by CLOs pre and post-closing.  That is not the end of FATCA requirements, however, as further complexities exist at various phases of the CLO lifecycle, most notably during the warehousing  and wind down stages.

As if that were not enough, the American Institute of Certified Public Accountants, the US regulatory body responsible for audit regulations, adopted new standards from May 2017 affecting CLOs. These require extensive representations from the applicable issuer for effective date, cash flow and quarterly reports with those reps being required within a short time frame of the close of those periods.  Importantly at the SPV issuer level, this has required additional staffing and expertise so as to enable applicable issuers to check and validate the representations being given, to liaise with the applicable parties who have the requisite knowledge, typically the collateral administrator and/or trustee and/or collateral manager, so as to develop protocols to obtain appropriate comfort and comply with the tight timelines.  Clearly, just taking into account the various US regulatory initiatives implemented over the last six years or so, an immense level of expertise is now required at the SPV issuer level to successfully navigate the CLO 3.0 landscape, both to apply the legislation and allocate resources  through the life of the deal to ensure compliance. Practically speaking, it also means that arrangers and investment managers have had to dramatically step up their due diligence on service providers, who can differentiate themselves through their ability to develop bespoke structuring solutions to meet the requirements of such an enhanced regulatory landscape.

The Maples Group excels in this respect and takes an approach that strives to meet the requirements of such an enhanced regulatory landscape.  With regard to FATCA, for example, Maples Group directors have worked to ensure greater discipline around the warehousing and liquidation stages of CLOs to resolve outstanding issues, to collaborate with trustees to design implementation plans for reporting and to introduce relevant provisions to indentures to deal with these new requirements as well as to develop additional disclosure language for offering memoranda to protect all relevant parties.

European Legislation – US Impact

Meanwhile, in Europe, five key pieces of regulatory legislation in the past three years have created further complications for US CLO issuers, in some circumstances regardless of whether European investors are actively being targeted, cementing the view of a radically altered regulatory environment for CLOS.

The Market Abuse Regulation, implemented in 2017, applies to issuers whose securities are listed on EU stock exchanges and, unlike the prior European regime it repealed, now extends to unregulated securities markets like Irelandʹs Global Exchange Market, where the vast majority of European CLOs, and a large percentage of US CLOs, list their notes.  While the impact of this EU regulation is in practice relatively limited for asset-backed securities, which are less prone to the existence and management of non-public price sensitive information and other market abuse risks compared to listed shares of corporates, US CLOs now in scope of the regulation were required to adopt relevant policies and procedures and US collateral managers without a presence in the EU needed to be educated  about their  ongoing obligations  arising out of this regime.

With these dynamics in mind, Maples Group directors have responded to these challenges by developing a variety of options to enable issuers to comply with these requirements  with the least amount  of disruption for arrangers and investment managers.  Whilst some managers have looked at delisting of notes immediately  or upon a reset or refinancing  at the issuer’s option (and simply not listing at all for new deals) or listing on an alternative exchange outside of the EU, such as in the Cayman Islands or Jersey, we have developed a solution to provide the necessary back-up and services to comply with the new rules so as to maintain the listing in Ireland, the exchange historically preferred by investors.

The Markets in Financial Instruments Directive (“MiFID II”) legislative regime, meanwhile, which took effect in January 2018, represents one of the most pervasive regulatory frameworks for the financial markets industry, both in its impact for buyers and sellers and also in terms of its geographical reach.  US arrangers and investment managers may be caught by MiFID II in a number of ways, including where they operate European managed accounts, deal in European securities or with European counterparties, distribute funds in Europe or deal in instruments that reference European securities. With its focus on transparency, MiFID II requires key risks of a deal to be succinctly disclosed to noteholders and introduces a host of new rules including reporting obligations and LEI registration when trading swaps.

MiFID II came fast on the heels of the European Market Infrastructure Regulation (“EMIR”) that was introduced to regulate over-the-counter (“OTC”) derivatives.  EMIR introduced  new margin rules  for un-cleared derivatives.  Whilst most US CLOs are not in scope of EMIR as they do not enter into OTCs with EU swap counterparties, the Maples Group has adopted solutions for elements of the market nonetheless affected by EMIR.  For example, for EU swap counterparties that face non-EU swap counterparties in non-netting friendly jurisdictions, issues around the enforceability of margin collateral in those jurisdictions now means that these EU counterparties face potentially higher regulatory charges as a result and this has also led to additional reporting and compliance burdens. Structuring solutions have been implemented by some parties so as to avoid these additional complexities and costs, including the interposition of SPVs between the EU swap counterparty and the non-EU swap counterparty.

Whilst not applicable to the vast majority of US CLOs, the EU’s General Data Protection Regulation (“GDPR”), which came into effect on 25 May 2018, introduced new and significantly enhanced obligations for those that collect, process and control personal data of EU citizens.  More importantly, however, the extra­ territorial scope of GDPR has the potential to catch non-EU SPV issuers, including CLOs, which have EU investors or counterparties and where the GDPR risks arising from any SPV ownership or receipt of relevant personal data are not managed correctly.  This creates additional risk and responsibility, primarily in terms of who has to comply, which is likely to fall on the SPV who is likely to be deemed to be the data controller.  This also brings additional obligations on SPV directors, requiring them to ensure that the issuer complies with applicable requirements as they are treated as ultimately responsible in that regard, and also requires them to ensure that administrators who process data on the issuer’s behalf are compliant with the regulations.

Finally, the long-awaited EU Securitisation Regulation (which applies as of 1January 2019), has resulted in additional complexity for US CLOs, arrangers and collateral managers, in particular when selling the CLO securities to relevant EU investors.  The initial diligence and ongoing transparency and reporting requirements, let alone the risk retention requirements, of this regime need to be considered in such a scenario and where the US CLO is required to comply inevitably the SPV directors and the corporate services provider will be called upon to assist.

Successive Global Initiatives

Another wave of regulatory initiatives has hit CLO shores in the past couple of years, albeit more global in genesis.  This started with laws designed to create beneficial ownership registers for owners of companies, initially implemented in the UK and then in its overseas territories and Europe, so as to enhance tax transparency and assist in the global drive to prevent money laundering and terrorism.  In regards to the specific challenges on beneficial ownership, coming out of the EU’s Fifth Anti-Money Laundering Directive, a certain level of expertise and resource is required from the SPV issuer to comply.

In this context, the Maples Group has introduced structuring solutions focused on Delaware co-issuers not having to issue capital and providing options for the wind up of co-issuers post December 2017.

Stricter AML regulations in the Cayman Islands, introduced in 2017, extended know your client (“KYC”) obligations to SPVs and, while industry guidance notes are less than clear, issuers now deal with significantly increased KYC requests from EU and Asian investors.  Notably at the SPV level, greater expertise and resources are needed to analyse and implement the rule changes, both at the outset, and throughout the life, of a transaction with an SPV.

Maples Group directors, meanwhile, have helped to streamline protocols surrounding warehousing and account opening for the benefit of clients, while the groupʹs ability to provide a full suite of AML solutions has been well received given limited bandwidth and appetite to undertake this work elsewhere.  The latest worldwide initiative, which has been underway for some time now, sponsored by the OECD and called the Base Erosion and Profit Shifting (“BEPS”) project, was introduced in the past year.  Its aim is to ensure that geographically mobile activities are taxed appropriately in the jurisdictions in which the associated profits are generated although the application for capital markets SPVs is still uncertain.  There is no doubt that this latest initiative further raises the regulatory compliance bar for service providers.  Few would argue that, having just gone through such an intense period of regulatory overhaul, BEPS feels like the straw that broke the camel’s back.  Simply put, the additional regulatory burden created over the past few years means that the workload on service providers and directors of SPVs has increased significantly.  The heavy lifting, additional knowledge and manpower now required to comply with this increased regulatory environment  during the lifecycle of a new CLO 3.0 transaction, for example, represents a seismic shift from what was required in the old CLO 1.0 deals.  A laser focus now needs to be brought to bear on those fiduciary providers seeking to service these deals.  What is definitely clear is that not all service providers are created equal and not all service providers have the resources, staff or capability to service these transactions at the prudential levels now required as a result of the massive increase in regulatory oversight and compliance.

The CLO 3.0 Landscape

In examining the dramatic shift in the regulatory landscape for US CLO market participants, it is worth considering how transaction documentation has evolved as a consequence.  Significantly, risk factor disclosures  have been ratcheted up, notably as a result of the new levels of transparency required by MiFID II, alongside mechanisms to allow the disclosure of noteholder and payment information.  Entirely new provisions have been incorporated to deal with FATCA, CRS and AML and the provision of investor information to issuers, as well as new sections dealing with accounting changes.  Provisions to allow the removal of recalcitrant noteholders have also evolved, alongside amendments to CLO structures to create MOA, CMV and C-MOA structures that are risk retention compliant.  Although US risk retention rules out of the Dodd Frank legislation have effectively fallen away, the EU still has risk retention requirements.  This has left US arrangers and investment managers, whose deals have EU investors or assets, with a lack of clarity on how best to avoid falling foul of this regime.  There are on-going concerns that taking the EU manager­ originator route may result in the CLO falling outside of the ʹopen-marketʹ CLO exemption under the LSTA ruling whilst it is not yet clear that the sponsor route being opened to non-EU mangers next year, will completely solve the issue.  Although this presents some challenges, with the removal of Dodd Frank and the Volcker Rule still effectively priced in by the market, as President Trump has intimated, the prospect remains that a returning Democrat government could still intervene, leaving banks with their hands still tied.

More market driven than in response to any particular initiative, refinancing transactions have evolved to become  more  efficient  with transaction documentation now updated to anticipate and provide for such extensions, in effect making these deals quasi-permanent.  This  has  effectively  foreshadowed a more widespread shift to more permanent capital vehicles as the market has become more accepting of evergreen transactions.

Is Your Service Provider up to the Task?

Given the massive regulatory changes to the CLO landscape, trying to comply with the various regulatory initiatives introduced to the market since 2012 in isolation or on an ad hoc basis is no longer sufficient.  A holistic and pro-active approach is needed to meet the staggering demands now placed on CLO service providers and directors.  This requires an experienced team with the necessary skills set, depth of bench and technical and institutional support to effectively and efficiently handle all of the additional burdens now faced by 3.0 CLOS.

With no sign of any slowdown in the pace of regulatory change, arrangers  and investment  managers operating in this environment would be well advised to seriously consider whether the directors of their SPVs have the requisite expertise and resources to effectively deal with all of the expected issues, let­ alone the unforeseen ones, that can arise throughout the life of a CLO, as well as the heavy lifting required for day to day functions such as tax, AML and agreed upon procedures reporting. In that context we believe there are certain questions all arrangers or investment managers should be asking a potential service provider:

What experience do you have in facilitating compliance with new regulatory regimes?

The Maples Group’s Legal Services offering is the largest and most highly regarded among those operating in the leading International Financial Centres and through constructive dialogue with governments, regulators and industry associations, we have helped shape financial industry innovation and regulation in many of the jurisdictions in which we operate. Our professionals are thought leaders in their respective fields and we constantly strive to educate and inform our clients, on a pro-active basis, about the impact of regulatory change and compliance obligations.

What regulatory reporting obligations can we outsource to you?

With unrivalled expertise in all aspects of regulatory disclosure and anti-money laundering compliance, outsourcing these functions to the Maples Group alleviates the strain of meeting complex and constantly evolving regulatory obligations without the drain on precious internal resources.  From FATCA and CRS, to bespoke AML evaluations, conflict advisory services, accounting, tax reporting and country by country reporting requirements, to name but a few, our professionals will ensure you are always compliant and comfortably ahead of the regulatory curve.

What expertise do your directors have to resolve the issues that arise over the life of a CLO?

Our directors, comprising highly seasoned professionals and industry veterans, have a wealth of knowledge and experience, drawing on decades of accumulated knowledge from the legal, accounting and investment banking industries. Significantly, our entire senior team and many of our group of 30 plus directors in the Cayman Islands alone, were working in the CLO fiduciary business before the credit crisis.  Many of them have first-hand experience of working through the challenges that the credit crisis created and working with counsel and counterparties to create solutions to resolve the most challenging scenarios, in many cases directly leading to the evolution of the CLO product from 1.0 to 2.0 and beyond.

How do you problem solve for the practical impact of regulatory reform and the additional burdens it brings?

By providing cost effective reporting services to our clients, combined with our deep understanding of the regulatory environment, we can eliminate the difficulties of compliance across multiple jurisdictions, drawing on the specialist expertise  of  our professionals  and  institutional  infrastructure to develop customised and streamlined processes, including compliance implementation plans and structural solutions with enhanced deal documentation.

How is your offering unique relative to your competitors?

The Maples Group, encompassing our legal, fiduciary and fund services businesses, alongside regulatory and compliance and entity formation and management, has expanded to comprise over 2000 industry professionals globally.  By growing organically to this size, with no acquisitions, we have maintained a consistent client driven culture, with collegiate teams dedicated to placing client needs first and attaining the highest standards of professional service across everything we do.

How does your footprint mirror our jurisdictional needs?

Operating from 18 international locations, including all of the major CLO jurisdictions, the Maples Group has a strong presence in the markets where our clients need us to be.  Significantly, we have grown in line with the jurisdictional  requirements  of  our  primarily institutional clientele, offering breadth, depth and a high level of expertise in the jurisdictions that are most relevant to their businesses.